Business Line of Credit: How It Works

Business Line of Credit: How It Works

Small business owners rely on business lines of credit for short-term money needs. A business line of credit is similar to a credit card in the sense that you are approved for a maximum credit limit. You can borrow and withdraw funds as you need them, up to the limit.

You are charged interest only on the amount you withdraw. As you repay the amounts you borrowed, you free up the line to again withdraw those amounts.

A business line of credit is a popular type of funding. According to the 2020 Small Business Credit Survey (Federal Reserve Banks), 40% of small businesses applying for financing seek out business lines of credit.

What is a Business Line of Credit?

A business line of credit is a type of small business financing that you can draw on periodically, up to an approved credit limit.

Its number one advantage is flexibility. You borrow only the funds you need when you need them — you are not forced to take out the full amount in a lump sum. And you pay interest on the money you draw out, only, not on the full amount. So it is cost-effective.

A business line of credit is a valuable strategy for managing cash flow. That’s because sometimes expenses hit when your business checking account is low. For example, you may need money to make payroll because sales were unexpectedly down or you had a business emergency. In that case, you can tap into the line of credit.

Or perhaps you want to buy inventory and take advantage of a bulk discount. But sales are slow right now. A temporary cash flow dip doesn’t cause you to miss out on a savings opportunity.

How Does a Line of Credit Work?

A small business line of credit works like a credit card in some ways — yet it is different.

When you establish a line of credit, it means your business gets approved up to certain credit limits. The lender determines the amount based on your ability to repay, the business revenue, your credit score and other factors.

Think of it as a contingency fund. The money is there if and when you need it.

A line of credit is revolving credit. With a revolving line, as you repay the amounts you borrow, the funds then become available to borrow again.

The following business line of credit example further illustrates how a line of credit works.

  • In January, the lender approves a business line in the amount of $50,000 for your business.
  • In April, you experience a temporary cash shortfall. So you borrow $10,000 on the credit line.
  • You are charged interest on the $10,000 you borrowed, only.
  • You must pay interest and principal on repayment terms established by the lender, until the amounts you borrowed are repaid.
  • Once any funds are repaid, those amounts become available to borrow for other financing needs.
  • If you need more money later, you can go back and borrow more up to the maximum limit available.

What Can You Use a Line of Credit For?

You can use business lines of credit for any legitimate business needs or expenses.

Many FDIC banks today require business borrowers to certify that they are not involved in illegal or high risk activities, such as online gambling or payday lending. Aside from such activities, there are typically no restrictions on how small business owners use lines of credit. Companies use business lines of credit for:

  • operating expenses,
  • equipment funding,
  • inventory financing,
  • software installations,
  • buying new computers or mobile devices,
  • paying unexpected bills or invoices,
  • paying employees,
  • growth opportunities,
  • emergencies, or
  • any other small business expense.

Seasonal businesses often rely on a credit line for working capital needs. Seasonal businesses may need to prepare for the high season, such as by buying inventory or raw materials. Or they may simply need money for cash flow to meet short term needs.

Some banks let you link your business line of credit to a business checking account as overdraft protection to avoid costly fees.

How to Access Funds

There are three main methods to access money from business lines of credit:

  • Checks: The lender typically issues checks to the borrower upon the account opening. Then the borrower writes checks for specific amounts.
  • Debit Cards: Depending on the lender, borrowers may also be issued a special debit card (such as a MasterCard) to access money.
  • Balance Transfers: If a business line of credit is through the same bank as the owner’s checking account, transferring cash into a checking account is especially easy. In those situations, the owner often can transfer funds online, by mobile app or even by phone into a business bank account.

Each time you write a check, withdraw or transfer a sum, you are borrowing money from the line.

How do You Qualify for a Business Line of Credit?

Most lenders have three minimum qualifications you must meet:

Time in business: You must have been operating and in business for a minimum amount of time. Most lenders require a minimum of one or two years of time in business.

Annual revenue: Your business must have a minimum amount of annual revenue. Once again, this varies by lender. Some require as little as $25,000 in yearly sales — although that would be unusual. Most lenders want to see at least $100,000 in annual revenue. For some credit line products you may need $250,000 or more. For the most favorable terms or a long-term line of credit, you might need a much larger revenue number, such as $1 million.

Credit history: You must have an established credit history including a good personal credit rating. Credit scores of around 600 usually are a requirement. Here again the credit score requirement varies by lender. A poor credit score may not prevent you from getting a credit line — but you may end up with less advantageous terms, such as a higher interest rate or lower credit limit.

About 79% of small business owners who apply for business lines of credit are approved for at least some amount. That’s according to the Federal Reserve Bank’s 2020 Small Business Credit Survey, as this chart shows.

business line of credit approval rate

Documentation for a Business Line of Credit

The lender underwrites business credit lines just like any other loan product. The lender also performs a check of your personal credit score and business credit score.

Every lender’s requirements differ, but lenders typically ask for the following type of documentation for a business line of credit:

  • Personal and business tax returns (last 2 years)
  • Bank statements
  • Balance sheet
  • Profit and loss statement (P&L)
  • Accounts receivable aging report
  • Personal financial statement showing the owner’s net worth
  • Business documents (such as LLC or incorporation articles)
  • Tax ID number / social security number
  • Information about other owners (if any)

You can generate the balance sheet, P&L statement and accounts receivable report easily using most accounting software. The lender usually supplies a standard form for the financial statement.

Some lenders ask for a business plan but most small business owners don’t have one. So the lender usually settles for a brief description of the business. The loan officer will also ask questions during the application process.

How Much Will a Line of Credit Cost?

A variety of factors affect your costs. Each lender varies. The lender will disclose costs up front, but be prepared for the following:

Fees: Sometimes there is an origination fee charged when you first are approved. Also, most lenders charge a modest annual fee or maintenance fee, such as $100 a year.

Interest Rate: Interest rates on a business line of credit typically range between 5% up to around 15%. However, rates can go higher. The lender will quote a specific rate upon loan approval.

  • Often the interest rate is quoted as “prime +” which means that it is based on the current prime rate, plus an additional percentage. Currently prime is 3.25%. So if a lender charges prime + 1.75%, your rate would be 5% at present.
  • Those with an excellent credit history generally get better rates. Read: How to Build Business Credit.

The lender will assess how big of a risk you are. The more risk the lender perceives, the higher your costs. Risk factors include:

  • The amount you request. Higher amounts mean more risk for the lender.
  • The nature of your business or industry. Some industries are riskier than others.
  • Your length of time in business. Brand new businesses are riskier to the lender than those with a longer track record.
  • Collateral. The more assets you have for collateral, the less risk for the lender

Secured vs Unsecured Credit Line

A business line of credit can be either unsecured or secured. It depends on what the lender offers. Secured means that the lender requires collateral to ensure repayment. Unsecured means that no collateral is required. Here is a comparison of secured vs unsecured:

Unsecured Line of Credit

Unsecured business lines of credit have higher interest rates and usually have smaller maximum limits. For instance, banks like Wells Fargo and Bank of America currently offer versions of an unsecured line of credit for small businesses. The maximum in each case is $100,000. The interest rate charged usually is higher than a secured line.

An unsecured business line is good for startups or young businesses. Unsecured lines are also good for service businesses that do not have a lot of assets to serve as collateral.

Secured Line of Credit

A secured line of credit is usually for larger amounts. For many lenders, secured lines of credit are standard.

Most are secured by a blanket lien on accounts receivables, usually through a UCC filing in your state. The lender may also take other collateral such as equipment, banks accounts or inventory to secure a larger line of credit.

Secured business lines of credit may charge a lower interest rate with better payment terms than unsecured.

Business Line of Credit vs Credit Cards

As mentioned above, a small business line of credit is similar to a credit card. But there are real differences:

  • Interest Rates – A business credit card usually has a higher rate of interest — 15% to 24%. Business lines of credit, on the other hand, may be 5 to 15%.
  • Fees – If you are unwise enough to take out cash advances on your card, the interest rate can exceed 25%. On top of that, you may have to pay a cash advance fee. A business line of credit is more cost effective for cash advances.
  • Rewards – But what about rewards programs? If a credit card has a rewards program, then the cash back may offset some of the interest. However, most cash back is only 1% or 2%, so costs are still high.
  • Introductory Offers – Some business owners get lured in with a low introductory credit card offer. But that attractive introductory rate may last only for the first 90 days or 6 months.

When to Use a Credit Card

Credit cards are a good choice for small expenses or when you need convenience. For example:

  • Convenience – credit cards are convenient for business travel and online purchases in particular.
  • For small expenses – If you need to buy a small amount of office supplies or pay for a business lunch, business credit cards are ideal.

Business lines of credit are better where a credit card would be too expensive.

Difference Between Line of Credit and a Loan

A small business line of credit is very different from a regular business loan. A business loan is close ended — a fixed term that last longer than a line. Also, with a loan you must take the entire loan amount all at once.

When to Use a Business Loan

Business loans are a better choice than a business line of credit for any situation where you need more than a few months to repay the money or it’s a large capital investment. For example:

  • If you are buying an office building, a business line of credit would be a terrible choice because the repayment term is too short. Commercial real estate mortgages, by comparison, have longer repayment schedules — 10 to 25 years.
  • If you are buying expensive equipment it might be wise not to tie up a chunk of your working capital for a large planned investment. Instead, look into financing from the manufacturer or a term loan.

By contrast, business lines of credit are good for short term needs where it is not worthwhile to take out a business loan. For example, assume you are experiencing a temporary cash flow dip. You expect it to be resolved within 60 days when some large invoices are paid. A small business line of credit is perfect in this situation.

Summing Up the Advantages

A business line of credit allows the owner to sleep at night. Lines of credit are great for contingencies. It’s comforting to know that you’ll have necessary operating funds to manage your small business finances, despite temporary shortfalls in revenue or if surprise expenses hit. As one small business owner told us about lines of credit, “The money is there if you need it.”

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Anita Campbell Anita Campbell is the Founder, CEO and Publisher of Small Business Trends and has been following trends in small businesses since 2003. She is the owner of BizSugar, a social media site for small businesses.

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